Do not be conned, part 2

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Another defining feature of Ponzi schemes – and another reason they can be difficult to spot – is that their initial unconditional, high, fixed returns typically encourage many of the original investors to re-invest their capital and profits, rather than redeeming their holdings.

This feeds the illusion of an investment that others fear missing out on, and thus are quick to pile into, while also preventing the model from being tested by the usual market liquidity conditions – that is, normal periods of net outflows.

Most of us can still remember the aura of success that the name Madoff exuded in the months preceding the namesake company’s eventual collapse – as well as the shock, subsequently, that so many well-respected financial experts (not to mention regulators) had been taken in by the scam.

As stated last week, Charles Ponzi was an early American financial products innovator who achieved notoriety in the years just after World War I, after he came up with an investment scheme that spectacularly defrauded thousands of investors – and in the process gave his name to future investment entities of a similarly flawed nature.

In the case of Ponzi’s original scheme, one potential red flag that some investors might have spotted, had they known what to be on the look-out for, was Ponzi’s litigiousness. Early on, Ponzi successfully sued a writer who had suggested that it was impossible to deliver as high fixed returns as Ponzi was promising. This discouraged further investigative journalism that might have highlighted the problems with his scheme earlier. Instead, as history now tells us, the Boston Post was still giving Ponzi’s scheme favourable reviews until just two weeks before its collapse. It is interesting to note that it was at that point that Clarence Barron, one of America’s most important early financial journalists and a key figure in the development of Dow Jones & Co and the Wall Street Journal, observed that Ponzi wasn’t investing in his own company, and that the size of his scheme exceeded the total number of postal coupons in circulation – these were his investment category of choice – by a factor of almost 6,000. Unfortunately, no-one followed up on this.

What, then, should an investor look out for today, in order to avoid Pop Ponzi’s genetically-flawed descendants?

The first warning sign, of course, is an investment that appears too good to be true. On the other hand, advisers do not get prizes for choosing investments that are not any good – so by itself, this is a poor clue.

Therefore, every adviser kicking the tyres of an investment seemingly good enough to be worth considering needs to understand that his or her due diligence processes must be thorough. More thorough, indeed, than has been the norm until now for some, if recent media reports of investors having been put into less-than-ideal schemes are to be believed.

Indeed, many of the considerations that may have influenced advisers in the past might need to be revisited. In particular, advisers should be on the look-out for:

– Plausible stories, backed up by credible assets, but priced using artificial valuation models. Such investment stories abound across a wide range of seemingly attractive underlying asset classes, including property, resources and “financial contracts”, such as receivables, development mortgages, or litigation funding.

– Open-ended structures that (apparently) pay high fixed or consistent returns. The problems can arise when these are wrapped around illiquid or hard-to-price assets, such as highly-specialised properties or storage-unit container rentals. Being open-ended facilitates inflows, which repay redeeming early investors, and can give an impression of liquidity that may be false. As occurred during the financial crisis in 2008, open-ended funds can run into problems when too many investors head for the exits at the same time that asset prices collapse.

– A vague affiliation is claimed with well-known auditors, administrators or custodians, but the nature and limitations of the affiliation is not made clear. For example, an auditor whose mandate is simply to confirm valuations that have been prepared in line with stated models may well give unqualified audit opinions, whatever the limitations of the subjective model itself actually might be.

– Schemes that have attached themselves to worthwhile causes, which a sceptical observer might dismiss as a cynical way to distract attention from the offering’s deficiencies through ‘reflected respectability’. An example of this might be the promotion of green credentials by forestry funds, exploiting investors’ understandable desires to “save the planet”, while racking up 15% a year in “fixed” returns.

– Schemes whose promoters are quick to threaten legal action, and make frequent use of the device to silence critics. (From first-hand experience, I know how quickly dubious schemes move to threaten litigation against any unfavourable analysis.) What you want to see is a well-argued, numerically sound explanation of just why the critics are wrong.

– Unusually high incentives to introducers are also a typical feature of “mark to model” – if the underlying numbers are totally divorced from reality, then the hard cash in the pot can be spread around promoters and introducers very generously. Ponzi did the same thing, using a highly-paid team of distributors. The numbers say it all: if a 15% fixed return from 100% of the capital is unachievable, imagine how much more difficult it would be to realise if some 20% or more of invested capital is paid out to the parties responsible for devising and distributing the schemes, and never even reaches the investment assets.

Of course, there are exceptions to these warning signs. Most investment funds, for example, are open-ended, and the vast majority of these are respectable and robust and have well-known auditors, custodians and administrators.

To be continued…

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Graham Macdonald on [email protected]